Finding The Funds That Fit Your Needs

November 29, 2022

Decide Which Funds are Right For You

While less time-consuming than selecting and analyzing individual stocks, choosing an exchange-traded fund (ETF) or a mutual fund involves some analysis.

There are two broad starting points that will serve you well as rules to follow.

The first is to decide what your allocation needs are. The second is to start with broad-based index funds. These mutual funds and ETFs are typically the biggest and the lowest-cost offerings within their respective categories. They tend to offer the benefits of having low expense ratios, being tax-efficient, holding highly diversified portfolios and having above-average long-term performance. 

Not all index funds are the same, so it’s important to look at what index a fund is following. A large number of ETFs follow indexes specifically designed for them to track. If you are unfamiliar with a certain index, type the index’s name plus the word “methodology” into a search engine such as Google. This will typically lead you to a document explaining what the index is designed to track. 

If you are comfortable with or have a preference for active management, you can expand the universe of which mutual funds or ETFs you consider. When doing so, be cognizant of the data showing how relatively few actively managed funds are successful at beating their broad-based index counterparts over longer periods of time.

Invest in a Mutual Fund or an ETF?

Mutual funds and exchange-traded funds provide individual investors access to professionally managed portfolios. They offer investors access to diversified portfolios managed at a low cost. However, there are structural differences separating the two types of investments.

ETFs trade like stocks on an intraday basis. Investors incur trading costs such as the bid/ask spread (the difference between what buyers are offering and sellers are asking). Plus, when selling an ETF, investors can immediately reinvest the proceeds.

ETFs are bought and sold from other investors. The purchase of an ETF on the open market does not add dollars to the fund’s portfolio, nor does the selling of an ETF lead to an outflow of dollars. Rather, ETF sponsors issue and redeem shares based on interactions with authorized participants (APs). APs are typically large institutional investors. Based on demand, Aps can either request creation units from the ETF sponsor or redeem them. A creation unit typically comprises 25,000 to 200,000 shares of the ETF. The actual transaction involves either basket of securities matching the ETF’s portfolio, cash or a combination of the two. These transactions occur on an intraday basis and help to keep the market price of an ETF’s shares close to their underlying net asset value (NAV is the value of the assets each fund’s shares represents).

The big takeaway is that there are intermediaries between an ETF and the actual investors who are buying and selling shares of the fund on the open market.

Mutual funds are bought and sold only at the end of each trading day. The prices of mutual fund shares are also updated at the end of the day. When an order to purchase or redeem shares is placed by an investor, or the order is not executed until the end of the trading day. These purchase and sell orders are executed at a mutual fund’s end-of-day net asset value. Transaction costs–beyond any loads, redemptions or brokerage fees–are not included, but the dollars from such trades cannot be reinvested immediately, except into another mutual fund.

Dollars from purchases flow directly into the mutual fund. Sell orders pull money out of the mutual fund. This is why flows are often tracked. An increase in demand from investors gives s mutual fund’s manager more capital to invest. Redemptions reduce the amount of capital to invest. If redemption requests are high enough, a mutual fund manager may have to sell some of the portfolio’s holdings to free up cash to fulfill the requests.

The structure of mutual funds can also lead to capital gains distributions being passed onto shareholders. These are profits from the sale of securities realized by the mutual fund that were not offset by realized losses. Investors have no control over timing of such distributions, and there are years when mutual funds can have both disappointing returns and capital gains distributions. ETFs can also pass along capital gains distributions, but because they often fulfill redemption requests by giving APs securities from their portfolio instead of selling them, capital gains are realized less often.

Factors Influencing Your Decision

So, given all of the above, how do you decide whether to use an ETF or a mutual fund?

Part of the decision rests on the type of account you are using. Participants in workplace retirement plans such as 401(k)s are generally limited to mutual funds. Our Northvale platform allows purchase of stocks and ETFs in addition to mutual funds with zero account opening maintenance fees.

As previously noted, ETFs generally have the advantage when it comes to taxes. This is not universally the case. Mutual funds following broad indexes, such as the S&P 500, may also have low tax-cost ratios. The VAnguard 500 Index Admiral mutual fund (VFIAX) hads a three-year tax-cost ratio of just 0.4%, for instance. This means shareholders in the highest tax bracket saw their returns reduced by four-tenths of a percentage point due to taxes.

If trading on an intraday basis is important, ETFs may be preferable. Reasons why this would matter include trading strategies and a desire to use ETFs as a placeholder in a portfolio until a new stock can be found.

A final consideration is the type of strategy preferred. Active management largely remains the domain of mutual funds, though 28% of ETFs are now classified as being active. Factor strategies–such as those favoring value, momentum or low volatility–tend to be the domain of ETFs.

In many cases, mutual funds and ETFs can be interchanged. Investors should focus more on finding the right fund for their allocation needs as opposed to worrying about whether it is an ETF or a mutual fund.

Pay Attention to Index Returns

Regardless of the type of fund you choose, be cognizant of the influence that market conditions have on returns. The returns of any fund–or investment strategy for that matter–are significantly influenced by the performance of its asset class. Some best-performing index changes by year. The ever-changing leadership is why diversifying across asset classes and fund groups is important. 

The second thing to look at is the variation in returns. Bonds have historically incurred less volatility in their returns. The trade-off of including both stock and bond funds in a portfolio is lower returns over the long term. Investors must balance their needs for the growth of wealth over the long term against their needs to preserve wealth for shorter-term goals and spending needs, as well as their ability to withstand volatile market conditions.

Tiffany Lalremruati

tlalremruati@northvale.ae